Thursday, May 29, 2008

Jacob Hacker is back with revised estimates on family income volatility (ht Mark Thoma). In his earlier work he found a marked increase in the volatility of family income between 1973 and 2004. These conclusions were later challenged by findings from the CBO. In turn, Hacker responded to CBO here. Now, if Hacker could be so kind as to respond to another question, one that I raised earlier:

[W]hat role does the 'Great Moderation' play in this debate? A well documented fact is that there has been less volatility in aggregate economic activity since the early 1980s and this development is called the 'Great Moderation.' One study has found real economic activity volatility has fallen 50% over this time. Would not some of this decline in aggregate economic volatility be felt at the household or individual level? Is not the low U.S. household saving rates one indication of this development?

Some observers may look at the low U.S. saving rate and say it is the result of the global saving glut or the U.S. asset price booms. I am not convinced, though, these answers can provide the full explanation for the sustained downward trend in U.S. household savings. A more complete answer has to account for the possibility of improved household expectations arising from the long economic expansions of the past two decades that were interrupted by only mild economic downturns (i.e. the 'Great Moderation').

Clearly, this question reflects my macro background. But it is the question that keeps coming up in my mind when I read this family income volatility debate.

Tuesday, May 27, 2008

Robert Frank's NY Times column on using Pigovian taxes as an "efficient" way to deal with the negative externalities of gas consumption has generated some interesting comments in the blogosphere. The article also points to an important question that has been bugging me for some time. But first, the interesting comments. First up is Gabriel Mihalache who points out an important assumption in Frank's analysis:

...A Pareto improvement [from imposing a Pigovian tax on gas consumption] means that afterwards, everyone is at least as well off (subjectively) as before and some are better off. But how can that be the case when we’re talking about taxing externalities, given that some people’s income is tightly tied with those activities?

The implicit, unstated, assumption of Frank’s article is that we could compensate the losers from the new energy policy from the gains of others. By the logic of what a Pareto improvement means, the gain to some is larger than the loss of others, so there exist potential transfers to compensate the losers and still leave the winners better off.

When supporters of free trade point out that the net losers from the full opening of borders could be compensated, with transfers from the net winners, the common criticism is that those transfers are both politically and institutionally unfeasible. There’s no mechanism we can trust that would identify the correct transfers (from whom, to whom, how much?) and make it in a way that’s politically acceptable.

I will unashamedly yield the same critique against Frank. He wants to seduce us with Pareto improvements but he only tells us half the story, less that half really… he mentions introducing the carbon tax but he remains strangely silent on the ways he’d use to compensate the losers.

Gabriel suggests we avoid resorting to the Pareto efficiency argument and say up front there may be net losers. Josh Hendrickson, meanwhile, also questions the usefulness of invoking Pareto efficiency and goes on to stress that the proper use of a Pigouvian tax requires a Herculean ability to properly assess social costs:

The problem inherent in any such analysis is the view of societal benefit and societal loss that is assumed to be easily calculated and dealt with through Pigouvian taxation. The ability to identify the social cost of a particular action is extremely difficult as each individual has his or her own subjective valuation. The problem is communicating each of these preferences in aggregate form to some central authority. This is a distinct problem in terms of both Hayekian knowledge and a neoclassical framework (Arrow’s Impossibility Theorem). In the absence of this ability, setting the tax rate is extremely difficult.

In short, both of these commentators suggest we should be more humble about our ability to (1) rigorously justify and (2) precisely implement a carbon tax. As noted above, Frank's column also points to another important question that I have been wrestling with for some time: exactly which externalities should be internalized? There are so many negative externalities in society so why stop at those created by gas consumption? Frank alludes to this in his article:

Gasoline is one of a host of goods whose production or consumption generates costs that fall on outsiders. Noisy goods, like leaf blowers, for example, can jolt whole neighborhoods from calm. And goods that don’t biodegrade readily, like many plastic bags, can generate costly waste streams. The list goes on.

Okay, then, why not tax noisy leaf blowers (noise pollution) or billboards along the highway (sight pollution) or rancorous, smelly, ugly people (noise, sight, and smell pollution)? Conversely, should we subsidize quiet neighbors, firms that do not advertise on highway billboards, and beautiful, well-kept people?

Now I am not advocating we tax or subsidize the above items. However, this list does illustrate the fact that society does choose to correct only certain externalities. So what is the decision criteria used in this process? Presumably it involves equating some margins; I am just not sure which one they are though. Any thoughts?

In closing, let me refer you to Peter Klein who, in the context of applying a Pigouvian tax to negative externalities, makes the following statement:

But my main beef with today’s Pigouvians is that they cherry-pick a case here and there — taxes on gasoline, primarily — without fully pursuing the implications of the analysis. If increasing gasoline taxes is efficient, why stop there? What other market failures should the state be empowered to remedy? Here’s my question, specifically:

Please name the activities you believe deserve Pigouvian subsidies. For each activity provide the efficient subsidy amount, explain how this was calculated, and say how the revenues should be raised.

The Conventional wisdom on deflation is that it is economically harmful and should be avoided at all costs. Consequently, no central bank explicitly targets deflation and few observers would dare say anything nice about deflation. The origins of this deflation orthodoxy can be traced to the painful deflation experience during the Great Depression of the 1930s. Japan's experience with deflation and its weak economy in the 1990s only reinforced this view. The modern economic psyche, therefore, has been programmed to go into fits at the first sign of any deflationary pressures.

This aversion to deflation can seen in the figure below that shows the number of articles on U.S. deflation in major world newspapers and the U.S. inflation rate for the years 1992-2004. During this time there were two deflation scares--one 1998 and the other in 2003--when the inflation rate dropped below 2%. As you can see the number of deflation articles spiked around these deflation scares, with most of the articles expressing anxiety over deflation. [Click on graph to enlarge.]

[The number of deflation articles comes from Lexus-Nexus search with the keywords “deflation” and "United States" or "U.S." Included in the search was a string of words and word roots associated with deflation’s potentially harmful and adverse consequences (e.g. zero nominal interest rate bound, debt burden, liquidity trap, economic weakness). I assume that any article having these key words is expressing at some level anxiety or concern over deflation.]

As some of you know, I have a problem with this deflation orthodoxy because it fails to distinguish between deflationary pressures arising from a negative aggregate demand shock versus that arising from a positive aggregate supply shock. As the above figure indicates, almost everyone assumed the deflationary pressures in 1998 and 2003 were harmful when in fact the data suggests that much of it was the result of the rapid productivity growth in those two years. This deflation orthodoxy explains why the Fed lowered its policy rate to historic lows: it, like most everyone else, thought the deflation of 2003 was of the harmful form. Because of the deflation orthodoxy, then, the Fed pushed the real federal funds rate to historic lows at the very time the rapid productivity growth was suggesting a higher natural interest rate. As I have argued elsewhere, this set off a credit and housing boom-bust cycle that we are now trying to sort out.

I hope going forward that conventional wisdom of deflation will emerge to a more nuanced view that distinguishes between the harmful aggregated demand-induced deflation and the more benign aggregate supply-induced deflation.

When the laws are repealed, there are two possible effects. First, time devoted to religious pursuits unambiguously falls, as individuals choose to devote more time to work and more secular consumption. Second, there is an ambiguous effect on religious contributions. On the one had incomes may rise due to new work activities, and this could increase contributions. On the other hand, new secular consumption opportunities compete with religious giving for a share of the individual’s budget, and this could decrease contributions.

What, then, do the authors find?

Thus, secular competition does matter for religious participation: increased secular opportunities for work and leisure on Sundays lead to less time at church and lower religious contributions.

The authors also find that the repeal of the blue laws lead to a significant pick up in drinking and drug use by religious people. The authors conclude by discussing two implications of their research:

First, this finding serves to validate economic models of religiosity, as discussed extensively by Iannaccone (1998). Religious participation is not independent of economic influences such as the opportunity cost of church-going.

Second, this finding can be a valuable input into the discussion of the regulation of religion and substitutable activities. Absent strong negative externalities, there seems little argument for restricting the days of the week that commerce can take place. But religious participation may be one of those activities with such externalities. As such, secular regulations such as blue laws which promote religious participation can have external effects. Whether those external effects are sufficiently large to justify restrictions on commerce is an excellent question for future research.

I believe the negative externalities they are referring to is the steep pick up in drinking and drug use by religious people after the repeal of the blue laws. However, do we really want to mix church and state because some people are now making bad choices? I certainly would not want to make the case for more state intervention in order to promote religious participation, especially one that promotes participation on a particular day of worship. What about those who worship on Saturday or who do not worship at all? There are all kinds of problems with this supposed implication.

The euro is showing all the signs of strain of being the new international key currency. Manufacturers in Europe complain that its rise is imposing new levels of pain. Politicians in many countries across Europe are pressing to have more influence on monetary policy. For many of their constituents, the euro has become one of the whipping boys of globalisation. The euro is a much younger currency than the dollar was in 1944 and it exists in a political environment in which the governance structures for the new currency are not clearly defined. That makes the internal stakes within Europe much higher.

[...]

In 1944 the dollar became the world’s key currency because the US was both the world’s leading economic and military power. In 2008, the European Union has many economic advantages but also substantial political vulnerabilities. It is not easy being the world’s main currency. It is even possible that the new strains might lead to the break-up of the monetary union.

Friday, May 16, 2008

The Economist reminds us why the Malthusian perspective for today's world continues to be wrong...and why the Julian Simonperspective--absent some cataclysmic event--continues to be right.

Malthus the False ProphetMID an astonishing surge in food prices, which has sparked riots and unrest in many countries and is making even the relatively affluent citizens of America and Europe feel the pinch, faith in the ability of global markets to fill nearly 7 billion bellies is dwindling. Given the fear that a new era of chronic shortages may have begun, it is perhaps understandable that the name of Thomas Malthus is in the air. Yet if his views were indeed now correct, that would defy the experience of the past two centuries.

[...]

It was the misfortune of Malthus—but the good luck of generations born after him—that he wrote at an historical turning point. His ideas, especially his later ones, were arguably an accurate description of pre-industrial societies, which teetered on a precarious balance between empty and full stomachs. But the industrial revolution, which had already begun in Britain, was transforming the long-term outlook for economic growth. Economies were starting to expand faster than their populations, bringing about a sustained improvement in living standards.

Far from food running out, as Malthus had feared, it became abundant as trade expanded and low-cost agricultural producers like Argentina and Australia joined the world economy. Reforms based on sound political economy played a vital role, too. In particular, the abolition of the Corn Laws in 1846 paved the way for British workers to gain from cheap food imports.

Malthus got his demographic as well as his economic predictions wrong. His assumption that populations would carry on growing in times of plenty turned out to be false. Starting in Europe, one country after another underwent a “demographic transformation” as economic development brought greater prosperity. Both birth and death rates dropped and population growth eventually started to slow.

The Malthusian heresy re-emerged in the early 1970s, the last time food prices shot up. Then, at least, there appeared to be some cause for demographic alarm. Global-population growth had picked up sharply after the second world war because it took time for high birth rates in developing countries to follow down the plunge in infant-mortality rates brought about by modern medicine. But once again the worries about overpopulation proved mistaken as the “green revolution” and further advances in agricultural efficiency boosted food supply.

If the world's population growth was a false concern four decades ago, when it peaked at 2% a year, it is even less so now that it has slowed to 1.2%. But even though crude demography is not to blame, changing lifestyles arising from rapid economic growth especially in Asia are a new worry. As the Chinese have become more affluent, they have started to consume more meat, raising the underlying demand for basic food since cattle need more grain to feed than humans. Neo-Malthusians question whether the world can provide 6.7 billion people (rising to 9.2 billion by 2050) with a Western-style diet.

Once again the gloom is overdone. There may no longer be virgin lands to be settled and cultivated, as in the 19th century, but there is no reason to believe that agricultural productivity has hit a buffer. Indeed, one of the main barriers to another “green revolution” is unwarranted popular worries about genetically modified foods, which is holding back farm output not just in Europe, but in the developing countries that could use them to boost their exports.

More discussion is emerging across the blogosphere (here, here, here, and here) on how monetary authorities can better manage asset bubbles. This discussion has emerged in response to the Federal Reserve's own growing interest in this issue. The Financial Times first reported this development a few days ago and now the Wall Street Journal in both its print edition and in its RTE blog (here, here, and here) have been providing additional coverage. What we have learned so far about the Fed's thinking is that while it is open to using prudential regulation and monetary policy in stemming future asset bubbles, it is less enthused about the latter option. (This bias toward prudential regulation was especially clear in the speech last night of Fed governor Frederick Mishkin.)

Interestingly, what little discussion has been given to the monetary policy option has been framed around how monetary policy should respond given there is an asset bubble (e.g. prick it by increasing interest rate). What is not being discussed by Fed officials--at least I am not aware of any such discussions--is whether loose monetary policy itself helped create the U.S. asset bubbles of past decade. Ignoring this facet of the debate means ignoring discussions on how to improve the conduct of monetary policy so that it minimizes the emergence of asset bubbles in the first place. The RTE blog reports in a similar vein:

But amidst all this debate, the Fed has not dwelled much on the role its own monetary and regulatory policies may have played in fueling the housing bubble. James Biancoof Bianco Research complains that the Fed has looked everywhere for a solution but at itself. “It seems that the Federal Reserve thinks bubbles are caused be everyone and everything except, say, a 1% fed funds rate or special liquidity facilities,” he writes in a commentary today. If Mr. Mishkin wants to use the Fed’s powers more proactively to arrest bubbles, he “should stop voting for irresponsible expansions of Federal Reserve credit that create and promote bubbles.

While I differ with James Bianco regarding the Fed's clever use of its balance sheet to stem the current credit crisis, I do agree with the spirit of his argument--the Fed's loose monetary policies in the past was the fuel that started the asset bubbles. At a minimum it would be worthwhile to consider the asset price implications of its past policies and whether alternative approaches could do better. I have already expressed my view on this matter: the Fed would do a better job minimizing asset boom-bust cycles by adopting a nominal income targeting rule.

Let me close by noting that the Fed's is late in joining this debate. The Europeans have been thinking about these issues far longer. In particular, I would point any interested reader (or Fed official) to the works of Claudio Borio, Andrew Filardo, William White, and others at the BIS. These observers take seriously improving both prudential regulation and monetary policy. Here is a posting of mine that provides some links to their works.

First, he shows that Treasury Secretary Andrew Mellon was not an advocate of the liquidationist view, but actually supported stabilization policies. This may come as a surprise to you, as it did to me, given Mellon's famous liquidationist line: "Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate." White shows, however, that these words were attributed to him by Herbert Hoover in an attempt to salvage his own reputation by making Mellon appear as an indifferent "leave-it-alone-liquidationist." Moreover, White shows that Mellon actually called for monetary easing and some expansionary fiscal policy to stimulate the depressed economy.

Second, and more importantly, White shows that F.A. Hayek and Lionel Robbins were not the ardent liquidationists during this time that they are made out be by many contemporary observers. In White's own words:

The Hayek-Robbins (“Austrian”) theory of the business cycle did not in fact prescribe a monetary policy of “liquidationism” in the sense of doing nothing to prevent a sharp deflation. Hayek and Robbins did question the wisdom of re-inflating the price level after it had fallen from what they regarded as anunsustainable level (given a fixed gold parity) to a sustainable level. They did denounce, as counterproductive, attempts to bring prosperity through cheap credit. But such warnings against what they regarded as monetary over-expansion did not imply indifference to severe income contraction driven by a shrinking money stock and falling velocity. Hayek’s theory viewed the recession as an unavoidable period of allocative corrections, following an unsustainable boom period driven by credit expansion and characterized by distorted relative prices. General price and income deflation driven by monetary contraction was neither necessary nor desirable for those corrections. Hayek’s monetary policy norm in fact prescribed stabilization of nominal income rather than passivity in the face of its contraction.

This was interesting to learn because my understanding had been that Austrians love deflation no matter what form it takes (i.e. negative aggregate demand shock-driven or the 'malign' form versus the positive aggregate supply shock-driven or 'benign' form). That Hayek and Robbins believed in a monetary policy that aimed to stabilize nominal income means that they did differentiate between types of deflation. However, with that said White also reports

[t]he germ of truth in [Milton] Friedman’s and [Brad] DeLong’s indictment [of Hayek and Robbins as liquiditationists]... is that Hayek and Robbins themselves failed to push this prescription in the early 1930s when it mattered most.

So Hayek and Robbins should have pushed their nominal income stabilization views more forcefully during the Great Depression. However, even had they been more vocal they would have run up against the influential real bills doctrine that did not stabilize nominal income. So how the outcome would have differed is any one's guess.

Wednesday, May 14, 2008

The Financial Times (FT) is reporting that the Federal Reserve is looking for new ways to fight the assets bubbles of the future. In addition to better prudential regulation, the Fed is even considering--gasp--using its policy rate to nip an asset bubble in the bud. If you have been following the debate of asset bubbles at the Fed you will know this is a radical departure from past thinking. In the words of the FT:

The US Federal Reserve is reconsidering the way it deals with asset price bubbles in the wake of the housing and credit bust, in a move that could see the central bank using regulation – or even interest rates – to fight unjustified increases.

[...]

One option would be for the Fed to tackle bubbles with monetary policy, setting interest rates higher than they would otherwise be when asset prices appear to be inflating beyond levels justified by economic fundamentals.

Mr Bernanke rejected this approach in 2002 but is willing to re-evaluate it in the light of recent events.

Better prudential regulation and a willingness to take into consideration the possibility of asset bubbles in the conduct of monetary policy is progress. The tricky part, though, is how to modify monetary policy so that is responds in a systematic way to asset bubbles. One approach would be to simply add asset prices to a Taylor rule. However, even in a forward-looking Taylor rule with asset prices, monetary policy would only be responding to an asset bubble after it had emerged, after the asset bubble horse is already out of the barn. (This is because asset bubbles--which by definition are not based on fundamentals--cannot be predicted.) Would it not better to have a rule that minimized the emergence of asset bubbles in the first place?

I believe a nominal income targeting rule is just such a rule. In fact, for some time I have argued here that monetary authorities may actually increase macroeconomic volatility by aiming to stabilize some form the price level (e.g. inflation targeting), rather than nominal income. My reasoning has been that changes in aggregate productivity that are offset by monetary authorities, so as to maintain price level stability, can lead to economic imbalances. For example, in this post I said the following:

Imagine the U.S. economy is buffeted with a series of positive productivity shocks that increases aggregate supply. This development would put downward pressure on the price level and set off the deflation red alert sign at the Federal Reserve. Now, in order to keep the price level from falling, the Federal Reserve must act to increase nominal spending. If this change in monetary policy were unexpected, or if there were significant nominal rigidities (i.e upward sloping Short-run aggregate supply curve), the nominal spending increase that stabilizes the price level would also push actual output beyond its natural rate level. Hence, there would be both a sustainable component—the productivity gains—and a non-sustainable component—the monetary stimulus—to the subsequent increase in real output. Moreover, the unsustainable pickup in actual output would occur without any alarming increases in the price level ... The increase in nominal spending could thus create a boom-bust cycle in real economic activity without any of the standard inflationary signs of overheating.

In this scenario, had monetary authorities stabilized nominal spending--allowed the price level to fall while output increased--there would have been no positive output gap. Consequently, it would have been better for monetary authorities to stabilize nominal spending through a nominal income targeting rule. Note, that this understanding would also have implications for interest rates:

These developments could also be viewed from an interest rate perspective. Here, the Wicksellian view that the actual real rate of interest can deviate from the natural rate of interest in the short run is invoked. The natural rate of interest is the real interest rate justified by non-monetary fundamentals, specifically the productivity of capital, the labor supply, and individuals’ time preferences and is the real interest rate consistent with the natural rate level of output. Recall that an increase in the growth rate of productivity should be matched by a similar increase in the natural rate of interest. If, however, monetary authorities attempt to offset the productivity-generated deflationary pressures by lowering the policy interest rate, they may force the actual real interest rate below the natural interest rate. This response can create an unsustainable credit boom. The resulting macroeconomic disequilibrium will be manifested in unwarranted capital accumulation, excessive leverage, speculative investments, and inordinate asset prices...

Here again, in this scenario--which sound eerily familiar to the U.S. economy during 2003-2005--had monetary authorities instead stabilized nominal spending the real rate of interest would not have fallen below the natural rate of interest. To the extent a nominal income monetary policy rule prevents an asset bubble from emerging in the first place, it would be better than a Taylor rule that responds after the asset bubble formed. So how about it Chairman Bernanke and other member of the Fed: what do you think about a nominal income targeting rule as means to minimizing asset bubbles?

Thursday, May 8, 2008

Here is Claudio Borio's latest working paper. See my previous discussion of his insightful work here.

The Financial Turmoil of 2007-?: A Preliminary Assessment and Some Policy Considerations

The unfolding financial turmoil in mature economies has prompted the official and private sectors to reconsider policies, business models and risk management practices. Regardless of its future evolution, it already threatens to become one of the defining economic moments of the 21st century. This essay seeks to provide a preliminary assessment of the events and to draw some lessons for policies designed to strengthen the financial system on a long-term basis. It argues that the turmoil is best seen as a natural result of a prolonged period of generalised and aggressive risk-taking, which happened to have the subprime market at its epicentre. In other words, it represents the archetypal example of financial instability with potentially serious macroeconomic consequences that follows the build-up of financial imbalances in good times. The significant idiosyncratic elements, including the threat of an unprecedented involuntary "reintermediation" wave for banks and the dislocations associated with new credit risk transfer instruments, are arguably symptoms of more fundamental common causes. The policy response, while naturally taking into account the idiosyncratic weaknesses brought to light by the turmoil, should be firmly anchored to the more enduring factors that drive financial instability. This essay highlights possible mutually reinforcing steps in three areas: accounting, disclosure and risk management; the architecture of prudential regulation; and monetary policy.

FROM THE REPEAL OF THE BRITISH CORN LAWS TO THE END of collectivization in China and the former Soviet Union, the key to feeding a nation's people has been to let the market do it -- ably assisted by continuing progress in agricultural technology.

But countries from the Philippines to Haiti are forcing their farmers out of world markets so as to lower domestic prices. Then, the same governments that closed markets in order to control prices vainly demand that farmers plant and harvest more food, despite lower profit opportunities. Some also foreclose their farmers from using genetically modified seeds. Nearly all have reduced local investment in agricultural productivity, following the example set by wealthy governments and charities.

High prices for the world's food commodities have also frightened the countries that produce surpluses, some of them new to the market economy: Kazakhstan, which had been one of the largest wheat exporters, is now one of the largest hoarders; Russia has levied a 40% export tax on wheat; Ukraine imposed a wheat-export quota and Vietnam has banned rice exports.

Some countries have never caught on to market reality, despite decades of experience: Argentina imposed a 44% export tax on soybeans to keep local feed prices down. Others are taking leave of their senses: Singapore, which became wealthy through trade, is bidding up the price of rice to fill supposedly strategic stockpiles; the Philippines, short of rice, cuts off trade; and Thailand, a producer of rice surpluses, builds stockpiles to hold down domestic prices.

The biggest and most sophisticated market economies, the United States and the European Union, wrap their farmers in so many subsidies and protections that prices mean almost nothing. Despite the rising world prices of grain, European production is falling, with exports falling faster. U.S. production of grain is rising, but much of the new production is going to motor fuels -- ethanol made from corn is blended with gasoline and soybeans are being converted to biodiesel. Even so, there's a record amount of American food grain available for export, but not enough to replace supplies taken off the market by other exporters.

[...]

Around the world, food producers and their suppliers face the same type of discouraging experiences as oil producers. What is the point of assembling large tracts of land, investing in heavy equipment, irrigation, fertilizer, highly productive seed and other inputs if the outputs must be sold into price-controlled markets?

Wednesday, May 7, 2008

OIL briefly reached another record on Tuesday May 6th as West Texas Intermediate traded at over $122 a barrel for the first time. Ten years ago a barrel fetched around $15. The feeble dollar, soaring demand and supply constraints have all helped to push up prices by 25% in the past four months alone. And there is little sign of respite for worried governments and consumers. This week Goldman Sachs, a bank, predicted that oil could reach $200 a barrel before the end of the year.

Of course, many observers on the left and right believe higher oil prices are exactly what the U.S. economy needs. Higher prices are needed to motivate consumers and producers to substitute into a cleaner, less national-security related form of energy.

Tuesday, May 6, 2008

That it is what the intrade contract for a recession in 2008 is saying right now. The figure below shows the probability of a recession in 2008 as derived from this contract. Currently, there is only a 30% probability, a big drop from a few weeks ago. This contract, however, narrowly defines recessions as two quarters of negative growth for real GDP. It misses the massive collapse in the housing market and the related crisis in financial markets. Of course, U.S. recessions are officially dated by the NBER which takes a broader view of economic activity in determining whether there is a recession. It will be interesting to see how this all unfolds, especially since some observers think there is more economic fallout to come from the financial crisis. (Click on figure to enlarge.)

Update: Here is an article by Lakshman Achuthan and Anirvan Banerji that addresses the definition of recession.

NEW YORK (CNNMoney.com) -- Recession? Or just a slowdown? Some will tell you it doesn't much matter - that it's a distinction without a difference. Nothing could be further from the truth - or as dangerous a delusion.

Ignorance about recessions has taken hold because of a simplistic idea that a recession is two successive quarterly declines in gross domestic product (GDP), a measure of the nation's output.

The idea originated in a 1974 New York Times article by Julius Shiskin, who provided a laundry list of recession-spotting rules of thumb, including two down quarters of GDP. Over the years the rest of his rules somehow dropped away, leaving behind only "two down quarters of GDP."

Like most rules of thumb, it's far from perfect. It failed in the 2001 recession, for example. At the time and until July 2002, data showed just one down quarter of GDP, leading policy makers to claim there had been no recession. Yet, later that month, revisions showed GDP down for three straight quarters. Complicating matters further, with the benefit of time, we now know that GDP actually zigzagged between negative and positive readings, never showing two negative quarters in a row.

[...]

Clearly, there are times when the reality of the economy outside your window is harsher than GDP might imply.

[...]

Any trustworthy definition of recession needs to encompass the key elements of the recessionary vicious cycle - output, employment, income and sales.

[...]

A recession is a self-reinforcing downturn in economic activity, when a drop in spending leads to cutbacks in production and thus jobs, triggering a loss of income that spreads across the country and from industry to industry, hurting sales and in turn feeding back into a further drop in production - in effect a vicious cycle.

That's why the proper definition of recession cannot be limited to GDP and industrial production, but must also include jobs, income and spending, all spiraling down in concert.

To keep it simple, just look for the "Three P's" - a pronounced, pervasive and persistent downturn in the broad measures of those factors.

Sunday, May 4, 2008

As readers of my blog know, I have been following the debate over the U.S. Dollar's (USD) reserve currency status (here, here, and here). The key question in this debate has been whether the Euro will displace the USD as the main reserve currency going forward. The starting point for these discussion has been the economic profligacy of the United States and whether it, if sustained, is enough to overcome the network externalities currently supporting the USD. Although there is no consensus on this question, here is a fairly standard view compliments of Michael R. Sesit:

It isn't ordained that the dollar surrender its position as the world's go-to currency. Yet if Americans insist on living beyond their means, eschew sound fiscal policies, ignore the greenback's weakness and remain tempted by protectionism, the dollar will in small bites begin to mimic the British pound -- the currency of a once proud but spent imperial power.

Note what this line of reasoning suggests: good money--the Euro--will drive out bad money--the USD. But wait, that runs contrary to the commonly quoted Gresham's Law which says "bad money drives out good money." Is not Gresham's Law one of the great monetary truths we learn in our econ 101 and economic history courses? How could its implications be so off on this issue? George Selgin provides an answer. He tells us that Gresham's Law is not universal:

That bad coins have in fact often tended to drive better coins of the same metal out of circulation is beyond dispute. Yet historical exceptions to this tendency have been observed. Thus even in its narrowest meaning Gresham's Law must be said to hold only under particular conditions. What are these conditions, and why are they crucial?

These questions may best be answered by first considering those exceptional cases in which good coins appear to have driven out bad ones rather than vice versa. The most notable of such exceptions arose in the context of international trade, where, as Robert Mundell (1998) has observed, "strong" currencies, meaning ones that tended to retain their precious metal value over long periods of time, tended to dominate and drive-out "weak" (that is, less reputable) ones: "The florins, ducats and sequins of the Italian city-states did not become ‘dollars of the Middle Ages' because they were bad coins; they were among the best coins ever made." Less well known but equally important exceptions to Gresham's Law involved relatively rare instances of competitive coin production, one example of which was the competitive production of gold coins by private mints in California in the wake of the gold rush. Here as well it was the higher-quality coins that captured the market, allowing their makers to thrive while less reputable private mints failed (Summers 1976).

The main thing that distinguished these exceptions to Gresham's Law from other instances in which the law appears to have applied was the lack of any rules or of any authority capable of enforcing rules compelling people to accept particular coins in payment for goods or in the settlement of debts at some officially designated nominal value. Thus while the California private gold coins were, like those produced at the Philadelphia Mint, denominated in dollars, none of them were legal tender, and people were free to value them as they pleased, or to refuse them altogether. In practice only the better coins gained wide employment because others were not considered to be reliable representatives of the pre-existing dollar unit, and because valuing these inferior coins according to their actual gold content was inconvenient. In the market for international exchange media a similar tendency for good coins to be favored over bad stemmed from the absence of government authorities capable of enforcing legal tender laws and other rules compelling the acceptance of official coins "by tale" (that is, at par or face value, rather than by weight) beyond national borders.

Gresham's Law can hold, on the other hand, where both good and bad coins enjoy similar legal-tender status and where non-trivial sanctions can be applied to persons who insist upon discriminating against bad coin and in favor of good coin. In such cases all coins must be accepted by tale, and the employment of bad coin becomes a dominant strategy in what amounts to a "Prisoners' Dilemma" game in which both sellers and buyers participate. Buyers, knowing that sellers must accept either good and bad coins at their official face value, offer inferior coins, while hoarding, exporting, or reducing better ones; sellers, anticipating buyers' dominant strategy, price their wares accordingly (Selgin 1996)...

[...]

Failure to recognize the dependence of Gresham's Law upon laws interfering with the normal course of voluntary exchange has been responsible for some of the cruder misapplications of the law, including the tendency to treat it as describing the inevitable outcome of any sort of currency competition...

Properly understood, Gresham's Law refers to an unintended consequence of legislation the intention of which is to force people to treat a money they view as inferior as if it were not so...

Gresham's Law, therefore, is limited to money subject to the reach of national laws and does not apply to international reserve currency status. Read the rest of Selgin's article here.

Update: Richard Dutu, Ed Nosal, and Guillaume Rocheteau discuss Gresham's Law in this article. Like Selgin, they note the importance of legal restrictions, but also explain that asymmetric information can play a role. Finally, they indicate that Gresham's Law is less consequential under a fiat money regime. However, they note the following:

Still, there remains one factor that can put Gresham’s law into play today: government interference in the circulation of currencies. In high-inflation countries, when agents are free to choose their medium of exchange, the high inflation currency tends to be displaced by the low-inflation currency. This phenomenon, known as dollarization, is the natural outcome in a currency market with no imperfection. When the government raises the cost of using the low inflation currency, however, agents will be reluctant to use it in transactions and will keep it as a store of value. For instance, legal restrictions on the use of U.S. dollars in countries like Cuba and the former republics of the U.S.S.R have generated an outcome that resembles Gresham’s law. In all these countries, people could be punished for using dollars: Dollars could be confiscated and individuals could be fined. In accordance with Gresham’s law, legal restrictions raise the cost of using dollars and keep bad (domestic) currency circulating widely in these countries.

Saturday, May 3, 2008

Here are couple of articles that speak to the consequences of the Fed's actions since the outbreak of the financial crisis. From The Economist we learn that one reason for the run up in commodity prices is that the Fed is exporting its loose monetary policy to the world:

[...]

Another reason to suspect that the Fed is more than a bit player is that American interest-rate decisions have a disproportionate effect on global monetary conditions. Some emerging economies still peg their currencies to the dollar; many others have been reluctant to let their exchange rates rise enough to make up for the dollar's decline. As a result, monetary conditions in many emerging markets remain too loose. This fuels domestic demand, pushing up pressure on prices, particularly of commodities. All of which suggests that the Fed's decisions are propagated widely through the dollar.

[...]

So here we have another observer effectively claiming the Fed is a monetary hegemon and consequently, its choices affect many nations. I am glad I am not alone on this point. Closer to home we learn the Fed is now facing the consequences of its decision to rescue Bear Sterns from bankruptcy. Bloomberg's Craig Torres tells us that

...Chairman Ben S. Bernanke got an S.O.S. from Congress.

There is ``a potential crisis in the student-loan market'' requiring ``similar bold action,'' Chairman Christopher Dodd of Connecticut and six other Democrats wrote Bernanke. They want the Fed to swap Treasury notes for bonds backed by student loans. In a separate letter, Pennsylvania Democratic Representative Paul Kanjorski and 31 House members said they want Bernanke to channel money directly to education-finance firms.

Student loans are just the start. Former Fed officials and other Fed-watchers say that Bernanke's actions in saving Bear Stearns will expose the central bank to continuing pressure to use its $889 billion balance sheet to prop up companies or entire industries deemed important by politicians. The Fed satisfied Dodd's request today, expanding the swaps to include securities backed by student debt.

``It is appalling where we are right now,'' former St. Louis Fed President William Poole, who retired in March, said in an interview. The Fed has introduced ``a backstop for the entire financial system.''

Critics argue that the result will be to foster greater risk-taking among investors emboldened by the belief that the government will bail them out of bad decisions.

To be fair, though, the Fed believed the alternative to rescuing Bear Sterns was a systemic failure of the financial system. Fed officials understood problems like the above might arise, but were willing to risk them in order to avoid the greater costs of a financial meltdown. However, as Ken Rogoff notes in the same article,

They reduced the immediate risk of a crisis, but upped the ante of raising the possibility of a bigger crisis down the road.

So the Fed-bail-out genie is out of the bottle and investors have taken notice. As long as that genie stays out of the bottle there is no way to escape further regulation in financial markets as noted by Alan Blinder.

Friday, May 2, 2008

In a recent paper, Robert Hall makes two interesting assertions about employment over the business cycle. First, the "Great Moderation"--the reduction in U.S. macroeconomic volatility since 1984--is only a feature of output, not employment. Second, employment falls during a recession not because of increased job losses, but because new jobs are harder to find. Both of these claims were news to me so I decided to dig into the data myself.

Regarding the first assertion, Hall provides a figure (Figure 1 in the paper) that shows the percentage deviation of employment from trend does not noticeably change since 1948. It is not clear how he constructed the figure, but here is a graph from the Fred database at the St. Louis Fed that shows the monthly percentage change in employment over the same period:

Visual inspection of this figure indicates that employment volatility has diminished since 1984. Hall, in fact, does concede there does appear to be some reduction using this approach, but he goes on to claim that it has not declined as much as with output. Here is what I found looking at the standard deviation of the quarterly growth rate for both real GDP and employment (data from Fred database again):

The reduction of the standard deviation is of similar magnitude for both real GDP and employment. I fail to see, then, how the "Great Moderation" is more a feature of output than employment.

Regarding the second assertion, Hall provides a figure (Figure 2) that shows percent of workers laid off since 2000 has been relatively stable. This table was constructed using data from the BLS's Job Opportunity and Labor Turnover Survey (JOLTS). Digging into this data I was able to get numbers on layoffs and other separations, as well as new hires. I have graphed the data below:

This figure supports Hall's second assertion that employment falls during a recession not because of increased job losses, but because new jobs are harder to find, at least for the period 2000-2007 (unfortunately the data only begins in 2000). The impact of 2001 recession, for example, is visible in hires but not in the layoffs and other separations. The economic weakening that began late last year shows a similar pattern. Again, this is not what I expected.

If these patterns hold up going forward, then any good macro theory should be able to explain them. This was the whole point of Hall's paper.